Friday, October 31, 2008

Economist's Notebook: Prediction Markets

Economists LOVE prediction markets. And why not? Economists love markets and prediction markets have a pretty good track record. But I am an economist and I find little to love about these markets when it comes to politics. Above you see the current price for an Obama victory on Tuesday at Intrade. Currently, Intrade is pricing about a 84% chance of an Obama victory. That seems to make sense given what the polls and pundits are saying today, but wait, what is this less than 50% chance in the middle of September? Oh right, this is the post-convention bounce for McCain. But if prediction markets are somehow "wiser" than individual polls or pundits (or even a collection of polls and pundits) why has this mirrored them so closely? Shouldn't these wise 'crowds' have figured in the temporary bounce?

The reason for my view is simple: these markets are incomplete due to a lack of information and so while on average the mass participation should bring the variance down, individual markets are not telling us much that we don't already know. Investors in these markets are not privy to special information, they are guessing what other people will do. A recent look at the roller coaster that has been the Dow Jones Average this month should show you how good markets are at figuring that out.

All this is to say that while I see why prediction markets can do better on average than individual polls, I don't put a lot of faith in any one market. I think the 84% for Obama simply reflects the chatter as filtered by people who have money riding on it. Or probably reflects more the abandoning of hope that McCain will win. I think 84%, by any account, is far too high - reflects far too much certainty - for the first African American with a serious chance to win the white house.

If I have made Obama supporters nervous, here is some comforting news: look at the spike in Merkley's price (below), he is now at 73! That's pretty astounding for a race that is generally considered a toss-up.

One last thought, a friend and colleague at Dartmouth who - by right of living in New Hampshire - considers himself an expert on all things electoral, told me in June 2006 that there was no way Hillary would not be the Democratic nominee and his main piece of evidence was Intrade which had her at the time way up. [For the record, I predicted Obama and denounced Intrade] It is people like he that move the Intrade markets with little more wisdom than some obscure economics professor in Oregon who claimed to have a read of the zeitgeist of the this time in the US.

So, if I were a betting man (and I am not), I'd take the chance on McCain - you can buy him at less than 17!

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This blog seeks to comment on economic issues that matter to the state of Oregon. These issues may be local, state or national but in some way matter to Oregon and Oregonians. The goal of this blog is to eschew politics as much as possible and give an economist's perspective on economics and public policy as it relates to Oregon.

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